The recent spectacular increase in the UK wholesale natural gas price from less than 50 pence per therm in April 2021 to a peak of nearly 300 pence in October came as a complete surprise to everyone, including market traders engaged daily in buying and selling the commodity.
How did this happen?
The price of any commodity depends on the interaction of their supply and demand curves. In the case of gas there are some unique features which have produced the present spectacular outcome.
On the supply side, the effect goes back to early 2019 when the price fell from 60 pence per therm in January to around 25 pence in late October. In 2020 there was a further dramatic fall to around 10 pence in early June. By early October 2020 it was still only around 20 pence.
Similar price behaviour occurred elsewhere. In the US, for example, the price at the Henry Hub trading point in Houston experienced an equally dramatic fall.
The result of all this was a major reduction in new field developments. Industry cash flows were seriously reduced, and new field development investment fell substantially.
The year 2020 also witnessed the coming on stream the fruits of major past investments in LNG projects in various countries such as Australia and the US. The result was a major increase in supply at a time when demand was falling. Western Europe, including the UK, received substantial volumes of LNG imports contributing to the price fall. By 2020 LNG imports accounted for over 21% of UK gas supplies.
But these developments coincided with substantial reductions in world demand for gas. These emanated not only from the effects of COVID-19 but from the exceptionally warm winter in north west Europe which reduced the demand for gas not only for household heating but for electricity generation. The very low prices also encouraged the entry of new independent gas suppliers in the UK, which in turn was encouraged by many analysts.
Changing fundamentals
In 2021 the market fundamentals changed dramatically. Thus, cold weather in East Asia in particular produced a major increase in demand for LNG imports. In turn, this increased the wholesale price in the UK, reflecting the need for buyers to compete with the Asian market. The cold weather in the UK increased the gas demand for heating directly and indirectly due to low delivery of electricity from renewables and the subsequent increase in demand for gas for electricity generation. Over 80% of UK households are heated by natural gas.
As the year 2021 progressed gas demand worldwide remained relatively high. Chinese demand for LNG increased dramatically reflecting their policy to switch from coal to gas for environmental reasons.
On the supply side some of the new LNG projects had been postponed due to the dramatically low prices in 2019 and 2020. In the UK some new gas field developments have also been postponed due to stricter environmental regulations being required as a result of the COP26 meeting.
Meanwhile, gas stocks in the UK are at a very low level following the closure of the Rough field for this purpose.
A knock-on effect of the market for gas in many countries has been a spectacular increase in the price of emission allowances under both the UK and EU trading schemes. At mid-December 2021 these exceeded €80 equivalent per tonne.
In the period May-September the values were in the range of €50-60 equivalent per tonne, while the price of UK allowances has been particularly volatile.
Nord Stream 2
The position of Russia as a major gas exporter has attracted great interest, particularly regarding the Nord Stream 2 project. Russia is a major supplier to Western Europe and has the capacity to produce and export more. The Nord Stream 2 pipeline has a very large capacity, but a combination of opposition from the US Government in particular, and the finding of the EU regulators that the terms of the project as currently constituted do not conform to the EU Gas Directive have held up its coming on stream.
All this is taking place in the context of relatively low gas stocks in Western Europe at a time when peak winter demand is present and could last for a few months. Hence gas prices are both very high and volatile depending on the news regarding the prospects for Nord Stream 2 being sanctioned.
Prices at the UK National Balancing Point reached 294 pence per therm at mid-December with a daily variation (up or down) often exceeding 20 pence per therm. This is not unprecedented; in March 2018 on the occasion of the “Beast from the East” the UK price very briefly touched 300 pence per therm.
However, on 21 December the price escalated further to exceed 370 pence per therm, and on 22 December reached an astonishing 450 pence.
The near-term outlook is thus for continued volatility, depending substantially on the news regarding the Nord Stream 2 project.
From a purely economic viewpoint the stakes are high for both Russia and Western Europe. For Ukraine it is noteworthy that the transit fees from the current pipeline from Russia can exceed $1 trillion per year.
How does this affect the UK?
From the UK viewpoint, gas imports currently constitute over 50% of our demand. This is expected to continue. There are several substantial gas discoveries in the UK sector which should be economic at current prices even with strong environmental requirements and a substantial CO2 price. The result of their development would be increased economic activity, employment, and tax payments to the state.
Norway is an example of a country with strong emission-reduction policies combined with continued exploitation of its gas reserves.
As evidenced in forward prices the traders/market makers are currently expecting the UK price to fall substantially to around 80 pence in 2023 and even 60 pence by 2025. This can only be achieved if there is a significant increase in supplies and only a modest increase in demand in Western Europe.
Alex Kemp is a Professor of Petroleum Economics at the University of Aberdeen.
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